Knowles v. Commissioner

EDWIN C. F. KNOWLES, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Knowles v. Commissioner Docket No. 91495. United States Board of Tax Appeals 40 B.T.A. 861; 1939 BTA LEXIS 791; November 2, 1939, Promulgated *791 Petitioner, after his marriage, acquired interest in certain stocks, which, it is agreed, constitutes community property. Upon the question, at which time petitioner acquired interest in stocks of two particular corporations, the facts show that petitioner had no enforceable right to California corporation and Arizona corporation stock until after July 29, 1927, the effective date of section 161a of the Civil Code of California. Held, (a) the initial interest in the stocks was acquired after July 29, 1927; (b) petitioner's wife acquired a present one-half interest in the stocks under section 161a; (c) only one-half of dividends paid on the stocks in 1934 and 1935 is taxable to petitioner. B. J. Feigenbaum, Esq., and N. L. McLaren, C.P.A., for the petitioner. T. M. Mather, Esq., for the respondent. HARRON *861 The Commissioner determined deficiencies in petitioner's income tax for the years 1934 and 1935 in the amounts of $1,362.45 and $1,314.97, respectively. The question for determination is whether dividends received by the petitioner during 1934 and 1935 on certain stock are taxable one-half to petitioner and one-half to his wife, *792 as reported in their respective returns, or to the petitioner in their entirety, as determined by the respondent. FINDINGS OF FACT. The facts have been stipulated and are as follows: Petitioner is a resident of the State of California and was a resident thereof during the year 1926 and during the subsequent years, including 1935. Petitioner was married to Josephine K. Knowles prior to the year 1926 and they have been husband and wife at all times since their marriage. Marsh & McLennan, Inc., is a Delaware corporation. There are and were "associated" with the Delaware corporation four corporations bearing the name "Marsh & McLennan", incorporated in California, Arizona, Oregon, and Washington. Each corporation will be referred to hereinafter by the name of the state where the corporation was incorporated. The Arizona corporation, the Oregon corporation, and the Washington corporation are all operated in conjunction with the California corporation. The Delaware corporation is the parent corporation. In December 1926 C. C. Kinney, of San Francisco, was in the employ of the California corporation, was stockholder of the California fornia *862 corporation, and*793 shared in the dividends of the California corporation, and in the profit or loss of the Arizona, Oregon, and Washington corporations, all pursuant to the terms of certain agreements between Kinney and the Delaware corporation executed in 1918, 1923, and 1924. In 1926 Kinney desired to withdraw from employment and participation in all the corporations not later than December 31, 1929. Petitioner desired to enter the employment of the California corporation not later than January 1, 1927, and to become an officer and director thereof. In 1926 the Delaware corporation owned all of the stock of the California corporation, except ten shares standing in Kinney's name, and all of the stock of the associated corporations. On December 31, 1926, an agreement was executed by and between petitioner, Kinney, and the Delaware corporation. By this agreement, petitioner agreed to enter into the employment of the California corporation not later than January 1, 1927, and to become director and executive vice president of that corporation, and vice president of one or more of the associated corporations in Arizona, Oregon, and Washington; Kinney agreed to resign from his employment and from participation*794 in all the corporations not later than December 31, 1929, in which event, he agreed to sell to the Delaware corporation the ten shares of stock of the California corporation standing in his name; the Delaware corporation agreed that, upon acquiring the ten shares of stock from Kinney, it would sell the same stock to petitioner, upon certain conditions, to wit: (3) The Delaware Corporation agrees that, upon acquiring the said ten (10) shares of stock under the conditions set forth above in paragraph "(2)", provided and on condition that Knowles is then living and in the employ of the California Corporation and a director and officer thereof, it will sell and assign the same to Knowles under and subject to the following conditions: a certificate for five (5) shares of said stock shall be forthwith assigned and delivered to Knowles who agrees to immediately assign the same in blank and deliver to the Delaware Corporation to be held by it until such time as the dividends received by the Delaware Corporation upon the remaining five (5) shares of the said stock, plus or minus ten percent (10%) of the combined net profits or loss of the said Associated Corporations, as hereinafter provided, *795 shall have equalled in the aggregate the full amount paid by the Delaware Corporation to Kinney for the ten (10) shares of said stock under the terms of subparagraph "(a)" of paragraph "(2)", as amended, of the said California Stock Agreement, at which time (but in no event prior thereto as to any of said (10) shares of stock), provided and on condition that Knowles is still living and in the employ of the California corporation and a director and officer thereof, the ten (10) shares of said stock shall become the property of Knowles, subject to the further terms and conditions of this agreement. * * * On December 31, 1927, Kinney resigned from his employment with the California corporation and transferred and sold to the Delaware*863 corporation the ten shares of stock in the California corporation, standing in his name, for the sum of $60,689.21, paid by the Delaware corporation to Kinney. Kinney died sometime prior to September 24, 1928. On January 1, 1927, petitioner entered into the employ of the California corporation. On September 24, 1928, petitioner and the Delaware corporation entered into a new agreement, dated as of January 1, 1928. By this agreement, *796 the parties mutually agreed to modify the agreement executed by the same parties on December 31, 1926, and desired to set forth in the 1928 agreement all the terms and conditions relating to the matters, as between petitioner and the Delaware corporation, covered by the 1926 agreement. By paragraph M of the 1928 agreement, the parties expressly agreed as follows: M. * * * and it is expressly agreed that this Agreement contains the full and final agreement of the parties hereto relating to the matters referred to herein and the aforesaid Agreement of December 31, 1926 is hereby terminated and shall be endorsed as cancelled by the parties hereto and all copies thereof returned to the Delaware corporation. As between petitioner and the Delaware corporation, the agreement of September 24, 1928, set forth anew all the terms and conditions of the employment of petitioner by the California corporation and of the purchase of stock by petitioner from the Delaware corporation. The provisions for the purchase of stock were different from the provisions contained in the 1926 agreement. Petitioner agreed to buy ten shares of stock in each of the four western Marsh & McLennan corporations*797 instead of ten shares of only the California corporation stock. The agreed purchase price for the total forty shares of stock in the four corporations was $42,500, whereas, in the 1926 agreement, no certain price was stated for the sale to petitioner of ten shares of stock of the California corporation, but, by reference to another prior agreement with Kinney, the price was to have been approximately $1,000 for ten shares, plus an amount equal to dividends paid on the stock for two years. The method of paying for the total forty shares of stock, under the 1928 agreement, was as follows: Upon execution of the agreement, petitioner was to execute and deliver his collateral note for $42,500, payable to the Delaware corporation three years from January 1, 1928, with 5 percent interest, secured by the endorsed certificates for the forty shares of stock to be held by the Delaware corporation as security for the payment of the note and interest and for the performance of other terms of the agreement. Petitioner, also, was to simultaneously execute an assignment of one-half of the dividends on the stocks and a permanent dividend order directing payment of the dividends to the Delaware*798 corporation, one-half of *864 the dividends to be applied towards payment of the note and interest. It was expressly stated to be the intent of the parties that the note and interest should be paid out of the dividends on the forty shares of stock. It was also provided that no portion of dividends of the stocks from profits of the four corporations, for any year prior to the year 1928, should be payable to petitioner, or applied towards liquidation of the note, but that all such dividends should belong to the Delaware corporation, and the dividends to be applied to liquidation of the note should begin only with dividends payable out of profits for the year 1928; On September 24, 1928, the Delaware corporation issued and delivered to petitioner ten shares of the capital stock of each of the four associated corporations of California, Arizona, Oregon, and Washington, for $42,500, payable to the Delaware corporation, as provided for in the agreement executed on the same date. On the same date, petitioner delivered to the Delaware corporation his collateral note, dated January 1, 1928, for $42,500, payable three years from date, with interest at the rate of 5 percent per annum. *799 As collateral security for the note, petitioner, on September 24, 1928, deposited with the Delaware corporation endorsed certificates for ten shares of stock in each of the associated corporations, a total of forty shares, and assigned to it one-half of the dividends which might be paid on the shares of said stock, as security for the purchase price, said dividends to be applied in payment of the purchase price. Petitioner gave no security for the payment of the sum of $42,500, or any sum, other than the ten shares of stock of each of the four corporations, the assignment of one-half of the dividends thereupon, and an assignment of one-half of such additional sums as might be payable to petitioner, under the 1928 agreement, out of net earnings. The entire sum of $42,500 has been paid in full, solely out of the dividends paid on the stock of the four corporations, in the manner provided in the agreement of September 24, 1928. The ten shares of stock of each of the four corporations constituted community property of petitioner and his wife. The sale of the stocks and the taking of the note were not made on the faith and credit of the separate property of petitioner or his wife; *800 the stocks were not acquired or paid for out of the separate property or with proceeds from the sale of any separate property of petitioner; the stocks and dividends on the stocks have, at all times, been considered and treated by petitioner and his wife as their community property, and all dividends have been reported as community income, one-half by each spouse. The ten shares of stock in each of the four corporations were acquired after July 29, 1927. *865 OPINION. HARRON: It is conceded by respondent that the stocks of the four corporations in question were community property. It follows that the income from dividends on the stocks was community income. The question is, whether all of the income from dividends paid on the stock of the California and Arizona corporations in 1934 and 1935 is taxable to petitioner, a husband, or is taxable one-half to petitioner and one-half to his wife, under the community property law of the State of California. The particular question arises because of a change made in the community property law of California by enactment of section 161a of the Civil Code of California, 1 effective July 29, 1927. *801 Prior to enactment of section 161a, it was the law in the State of California, perhaps peculiar to that state, that a husband was the sole owner of community property and the wife had no title or vested, one-half interest, but only a mere expectancy, as heir, if she survived him. . Giving recognition to the peculiarities of California community property law, the Supreme Court held, in 1926, that income of community property may be taxed wholly against the husband. . The enactment of section 161a is regarded as expressing a legislative intent to change the theory of ownership in community property acquired after enactment of the*802 statutory provision, and to afford the wife a one-half interest therein. See 22 California Law Review, 417; 7 So. California Law Review, 13; , although the appellate courts of California have not yet passed on the effect of the enactment of section 161a on this point. At least, no decisions have been brought to our notice. However, the attitude of the Supreme Court of the United States, expressed in , and in cases cited therein, is highly significant. The Supreme Court in the Malcolm case recognized a proprietary vested interest in the wife (in California) in community income, by virtue of the provisions of section 161a, in community income earned by a husband after enactment in 1927 of the provision in the Civil Code, and held that under section 161a a wife had such an interest in the community income that she should separately report and pay tax on one-half of such income. It has been stated by California courts, however, that whatever the effect of section 161a may be on the rights of the respective spouses*803 *866 in community property acquired subsequent to its effective date, July 29, 1927, the new section of the code can not relate back to or govern the ownership of property acquired prior to the effective date. ; ; . See, also, ; certiorari denied, ; . It would appear to be the legislative intent that the effect of section 161a is limited to community property acquired after July 29, 1927, and is to give a wife a present, one-half interest in such property. It seems to be consistent with the view of the Supreme Court, expressed in the Malcolm case, that a wife should report and pay tax on one-half of income produced by community property acquired after July 29, 1927, the income acquired after July 29, 1927, being governed by the same rule applicable to other types of community income. See *804 . The question in this proceeding turns upon when the shares of stock in the Marsh & McLennan corporations were acquired. The respective rights of husband and wife in community property are determined by the law in force at the date of its acquisition. . Determination of the narrow question depends entirely upon construction of the agreements by and between petitioner and the Delaware corporation. Petitioner contends that on the crucial date, July 29, 1927, he had no enforceable right of any sort, under the agreement of December 31, 1926, other than a right to receive salary earned; that no interest in the stocks in question was acquired prior to July 29, 1927; that the interest in the stocks arose out of the 1928 agreement, rather than the 1926 agreement, because the second agreement, was intended to expressly cancel the first agreement. Respondent contends that petitioner acquired inchoate and vested rights in the stock, on December 31, 1926, upon execution of the 1926 agreement. The argument is that the "date of acquisition" is when an equitable interest arises*805 and not when legal title is transferred. Respondent contends, also, that the 1926 agreement was not canceled, as between petitioner and the Delaware corporation, by the 1928 agreement, but that the 1928 agreement supplemented and modified the 1926 agreement. First, putting saide the argument that the 1926 agreement was canceled by the 1928 agreement, the question to be considered is when petitioner acquired the initial right to the stocks in question, particularly in the stocks in the California corporation and in the Arizona corporation. The time when property is deemed by law to be acquired, as between husband and wife, is as of the time of the acquisition of the *867 initial right. See McKay, Community Property, 2d ed., par. 517, p. 352, where it is also stated that: * * * it is assumed the initial right of the series is of such character that it is recognized as valid in law or equity and is available against someone. It must be more than a mere unenforceable claim. [Italics ours.] Also, in a broad sense, contractual obligations are property, and such property, as between husband and wife, is acquired as of the date when the obligation becomes binding. *806 McKay, Community Property, 2d ed., pars. 531, 533, pp. 358, 359. Under the 1926 agreement, the obligation to sell petitioner stock in the California corporation, only, moved from the Delaware corporation to petitioner, and was subject to two conditions precedent - (a) acquisition of ten shares of stock of the California corporation by the Delaware corporation, from Kinney; (b) petitioner, at such time, had to be in the employ of the California corporation. Unless and until both of these conditions precedent were met, there was no binding obligation on the Delaware corporation to sell ten shares of California corporation stock to petitioner and, certainly, no binding obligation on petitioner to buy such stock. Turning then to the facts, it is clear that the obligation in the Delaware corporation to sell the California corporation stock to petitioner did not become binding upon it until December 31, 1927, on which date both the conditions precedent were met. On that date, petitioner was in the employ of the California corporation, and Kinney resigned and transferred the particular stock to the Delaware corporation. It must be concluded, upon reference to the terms of the*807 1926 agreement alone, that prior to December 31, 1927, petitioner did not have an enforceable claim against the Delaware corporation for acquisition of the California corporation stock; that petitioner did acquire his initial right to the ten shares of California corporation stock on December 31, 1927, and not before, which was after the crucial date, July 29, 1927. It is so held. It must also be concluded that, without any doubt whatever, petitioner did not, at any time, under the terms of the 1926 agreement, acquire any interest in shares of stock in the other Marsh & McLennan corporations in Arizona, Oregon, and Washington. Under the 1926 agreement, there were no obligations in the Delaware corporation to sell stock in any of these corporations to petitioner, and he was not obligated to buy any stock in these corporations. Without any question, and whether or not the 1928 agreement was supplemental to the 1926 agreement, or an entirely new agreement, petitioner acquired the initial interest in the stock of the Arizona, Oregon, and Washington corporations under the 1928 agreement and on January 1, 1928, and not before. It is so held. *868 Upon our conclusions*808 and holdings made above, it is unnecessary to consider whether the 1926 agreement, as between petitioner and the Delaware corporation, was canceled by the 1928 agreement. However, we are of the opinion that the parties intended to rescind the 1926 agreement by the execution of the 1928 agreement. We are of the further opinion that the 1928 agreement was not an amemdment of or supplement to the 1926 agreement, but was a new agreement, complete in itself, creating new rights and obligations as of January 1, 1928. See sections 1688 and 1699 of the Civil Code of California; ; . Since, under our holdings above, the stock in the California and Arizona corporations was acquired subsequent to July 29, 1927, the effective date of section 161a of the Civil Code of California, petitioner's wife acquired a present one-half interest in the stocks. Consequently, the dividends paid on the stocks in 1934 and 1935 are taxable, one-half to petitioner and one-half to the wife of petitioner. *809 It is so held. Respondent erred in including the full amount of the dividends in petitioner's taxable income. There is no deficiency for the year 1934. There will be a small deficiency for the year 1935 because of an uncontested addition to income in that year. Recomputation under Rule 50 is necessary. Decision will be entered under Rule 50. Footnotes 1. Section 161a. INTERESTS IN COMMUNITY PROPERTY. The respective interests of the husband and wife in community property during continuance of the marriage relation are present, existing and equal interests under the management and control of the husband as is provided in sections 172 and 172a of the Civil Code. This section shall be construed as defining the respective interests and rights of husband and wife in community property. ↩